In India, the ultimate goal of every middle-class Indian is to own a home. It may be a villa in the remote outskirts of a city or a narrow apartment in the city center, the goal is to own one.
Banks as usual understand this temptation and do their best to offer home loans at “attractive” rates. At the time of availing a loan, not everyone (including me) understand the long term implication of a housing loan with floating interest rates. Read on to get some some details.
Here is a simple math. Let’s assume the following loan is taken by an individual at the age of 30.
|Loan amount||Rs. 3,000,000|
1. The mountain of Interest
A rough calculation using an Excel calculator downloaded from internet, here are the repayment details.
|Monthly EMI||Rs. 29,951|
|Tenure||240 Months (which can increase, we will come to it later)|
|Total Interest||Rs. 4,188,335|
|Total Burden||Rs. 7,188,335 (Figure 1)|
|Age at completion||50 years|
A simple back of the envelope calculation indicate that you pay an interest that amounts to a whopping 139% of the principal (your actual loan amount).
Let’s keep these numbers aside, while we calculate the wealth at the end of this period.
2. The wealth in hand
The wealth in this scenarios is derived by the following means:
- The property (which is 20 years old)
- Yearly tax benefits
- Rental income (if let out)
Let’s handle this, one after another.
a. The Property Value
Assuming the loan was 80% funding, which puts the property value at purchase to: Rs. 3,750,000
To find the value after 20 years, we must consider the appreciation of the property value in the location and depreciation due to age of the property. Let’s ignore inflation for simplicity.
I put a hypothetical figure of 2% appreciation every year, considering the two factors. Using a compound interest calculator, here is the rough value of the property in 20 years.
Property value in 20 years = Rs. 5,570,000 (Figure 2.1)
b. Yearly tax benefits
As of this writing, the principal repayment utp Rs. 1 Lakh is exempted under 80C and the interest repayment upto Rs. 1.5 Lakhs is exempted under Sec.24 (full interest is exempted, if let out)
Let’s assume the house is let out at a rent of Rs. 15,000 per month.
So your yearly reduction is tax burden roughly amounts to (assuming top slab): 30% of Rs. 1 Lakh + 30% of Rs. 3 Lakh (rough interest).
But don’t forget your taxable income increases by Rs. 1.8 Lakh (rental income), where you pay an additional of 30% of Rs. 1.8 Lakh in tax.
In total, here is the yearly tax benefit: (0.3 * 100000) + (0.3 * 300000) – (0.3 * 180000) = Rs. 66000
Tax benefit in 20 years = Rs. 792000 (Figure 2.2)
c. Rental income
To be in line with our previous assumption, the yearly rental income will be: Rs. 180,000
Rental income in 20 years = 3,600,000 (Figure 2.3)
To sum up the approximate wealth (not lump sum) accumulated during this 20 year period will be the sum of figures 2.1-2.3:
Wealth accumulated in 20 years = Rs. 9,962,000 (Figure 2)
Evaluating the Cost, Benefits and Risks
A quick comparison between Figure 1 (burden) and Figure 2 (wealth) indicate a profit of roughly Rs. 2,800,000.
That is about a 38% profit, which doesn’t sound bad.
But here are the risks associated with the assumptions we made. Do read through them and beware they can have a big impact on the final figures.
- Property value may stagnate after a period of time. This is very much possible because the supply can reach dramatic heights vs the demand – thus leading to a stagnation (or worse, depreciation) of the property value
- Property may be dissolved. It is very much possible, if it is an apartment. In that case, you receive only the UDS (undivided share) as compensation which will roughly be about ⅓rd the property value
- Floating interest rate changes. It is a normal phenomenon. By default, banks increase the loan tenure, to maintain the same EMI. Thus you will probably extend your repayment schedule by 1-2 years (or more), hence increasing the burden
- Maintenance charges. These are charges relating to house maintenance, scouting for tenants etc. Though not significant, this can have an impact on your wealth
Mitigating the Risks
If you look at the overall figures, the interest plays a major role.
This means, it is a good candidate for attention.
1. Bring down your interest, as much as possible
This is normally achieved by:
- Periodically paying a lump sum to reduce your principal. Since for a major part of the tenure you will be mainly repaying the interest portion, reducing the principal can in turn reduce the interest
- Periodically increasing the monthly EMI amount. Assuming your income levels are on a constant rise, you can afford this and effectively reducing the tenure (and interest)
2. Dispose property if appropriate
Keep a close watch on your property price and the market. If you feel the property value has reached a peak and there is a possibility of depreciation, sell off.
3. If you are an NRI, use Property Management Agencies to manage your apartment
For a fee, there are property management agencies can take care of finding/retaining tenants, maintaining the apartment, payment of taxes etc.
Try to evaluate the benefits of using such agencies, if you are residing outside.
Buying a home with a housing loan is beneficial, if planned well. Otherwise, it may be a disaster in the long term.